Government of the people, by the people, for the people, shall not perish from the Earth. by Abraham Lincoln

Sunday, January 21, 2007

Why Does Government Exist?

In neo-classical economics, the market always has perfect information in which individuals have a full knowledge of how to exchange their transaction. However, in the real world information is not costless. There are costs of negotiating, enforcing the regulations and laws, and administration in economic exchange. A public choice economist, Coase, acknowledges the profound effect of transaction cost in order to improve the orthodox economic analysis derived from Adam Smith. My paper will try to illustrate some aspect of the application of transaction cost to an existing formal institution, government.

I. An Economic Perspective From Adam Smith

In his classic work “The Wealth of Nations” , Adam Smith gives us an economic foundation of how we can enjoy the mechanism of the division of labor in a pin factory. Instead of one man doing the whole process of making pins, the well-organized manufacturer can distribute each part of the pin-making process to distinct pin-makers, responsible for a couple of tasks only , which in turn will increase productivities. A practice of specialization is his main classic idea of “the invisible hand” where the prevailing price will determine the allocation of work in the market. However, Coase (1937) argues that economists have failed to apply economic theory to the real world if they omit the economics of good judgment of transactions cost into their analysis. I would apply transaction cost to explain why government does exist in the society by linking it to the Coasean theory of the firm . My first question is “Why do we need government?”

II. Governments As a Formal Institution

Theoretically, in democratic, socialist, authoritarian societies or other types of government, everybody can produce every product for self-consumption, but practically not everybody will be able to do this since there might be some reasons that negate this action such as constraint of resources, information costs, opportunity costs, etc. For example, a farmer can produce bushels of rice to feed his family and himself, and sell the excess products, but he might not be able to protect his farmland from the invasion of other states . On the other hand, government has its own almighty army but it cannot produce rice to feed its army. Once these two parties figure out that they can be better off by trading with each other, they can improve their social welfare. That farmer is willing to give away an extra bushel of rice in order to receive additional security up to the point where this outweigh is equal. This is the equilibrium of the free market in Adam Smith’s view where transaction cost is equal to zero. But in reality, how can an ordinary farmer know when the invasion will happen? It might happen routinely or it might be once in a while. In addition, when there is no central government to protect its own entity and boundary, should he fight for himself and also for other farmers who might enjoy the benefit of his action without any contribution? Or should he overcome the collective bargaining and set up the public agenda and gain a consensus to form a group of farmers to protect their community? It is clear that in this case gathering all pieces of information has a very high cost and uncertainty of invasion is an unpredictable future, where the price system in the market cannot work properly because of free ridings, undefined property rights, public goods, and so on or in the common word “Positive Transaction Costs.” In this situation, we cannot reach Pareto Optimality of the first theorem of welfare economics. It might be good to have a middleman, who has good managerial skills and some legal authority to mediate these problems in order to satisfy the second welfare theorem.

III Analysis

In order to have consistency to apply the Coasean Theorem of a specialized government of exchange economy and division of labor to accomplish the second welfare theorem in my framework, I assume that democracy is fully established in the society. This condition is a necessary condition and will give parsimony in my analysis. This is because the foundation of democracy is the regime that led Abraham Lincoln to say “Government of the people, by the people, for the people shall not perish from earth.” People will have freedom to use their own discretion to direct resources in the production the way they want. No one has more rights than the other. Everybody can acquire information in the market easily and with low cost. With this condition, the political market can assume to be close to perfect competition market where the first welfare theorem holds. Furthermore I also add some assumptions in a democratic state. First, everybody has equal rights and can express his needs by voting, which is granted by constitutions. With a well-designed constitution, it will state clearly what people’s rights are. No one can deprive these rights from others. Second, a complete contract between voters and politicians will reduce the principal-agent problem. Without a complete contract—such as check and balance system, political election rules, the social sanction to politicians who perform inefficiently—politicians might break the promise to voter citizens, once they win the election. This is an extreme case describing our world as an ideal place. Everything works fine in this framework. Government exists only as other business firms do. But when I relax some of my assumption that if the cost of getting some information is not costless and this cost is not spread equally among people, what will happen to the ones who have the cheap channel to get information over the one who does not? And what if government once it possesses the power decides to enjoy its own perquisites instead of doing good to the society? Once we have an elected government, we should consider the second question. What is the scope and size of the government? As professor Coase has mentioned that “…it might be replied that under perfect competition, since everything that is produced can be sold at the prevailing price, then there is no need for any other product to be produced. But this argument ignores the fact that there may be a point where it is less costly to organize the exchange transactions of a new product than to organize further exchange transactions of the old product…” In my framework, not only government limits the expansion of its scope of tasks and public policies up to the point where marginal cost of managing transaction exchange equates to marginal benefit, but it is also bounded by law and constitution because constitution will grant the limited authority to government for legal actions. No actions of government will be justified without sanction by laws.

IV Summary

In conclusion, the problems of the high cost of acquiring information and uncertainty can link to transaction costs by using Allen’s definition. This positive transaction cost is the biggest cause of market failure in Coase’s view. He believes that good management to direct resources in the production process like the one in Adam Smith’s classic pin factory can fix market failure. No exception in political arena, along with my assumptions that well-defined constitutions and a complete contract do hold in democratic state, government will arise as a social mediator that will reconcile the conflicts of the people and direct resources to production. The size of the government is limited by economic marginal cost and marginal benefit; furthermore, it is also bounded by constitutions and laws (the latter is more important). The Coase theorem, “The Nature of the Firm,” can explain why government does exist in our society.